Invest in This Hot Market the Right Way

A falling yen has sparked renewed interest—and gains—in Japan’s stock market...but American investors should look at ways to reduce currency risk, such as this hedged ETF, writes Nicholas Vardy of The Alpha Investor Letter.

After spending almost two decades in global investors' doghouse, Japan has become the hottest major stock market on the planet—seemingly overnight. Tokyo's benchmark Nikkei index has surged 32% since mid-November, to mark its longest winning streak since Japan's 1980s "bubble economy."

Japan is now the world's best-performing major stock market over the past three months. Global Japan equity funds recorded their biggest yearly inflow in 2012 since 2005. In ten of the last 12 weeks, stock funds have attracted $3.09 billion.

So why the big change in sentiment about Japan's stock market? Investors are optimistic that economic reforms being pushed through by Japan's new Prime Minister Shinzo Abe will wake the Japanese economy from its 20-year slumber. And they believe that corporate profits of major exporters in Japan are set to soar, thanks to the systematic weakening of the yen.

Despite the huge headline rise in the Japanese stock market, US investors haven't benefited much. The Japanese market has rallied by one-third in yen terms on expectations of an economic and corporate rebound. But, thanks to a 14% decline of the yen versus the US dollar over the same period, US investors have not seen the value of their Japanese investments rise at nearly the same rate.

WisdomTree Japan Hedged Equity Fund (DXJ) offers a solution by hedging out or neutralizing the effects of the currency risk of the declining yen. I'll come back to it in a minute.

Since its financial bubble burst over 20 years ago, the Japanese stock market's weighting in global investors' portfolios has dwindled from about a third to around 8%.

After getting elected for the second time last December, Prime Minister Abe called for a "regime change" at the Bank of Japan (BoJ)—in the form of a new Central Bank governor who would lead a bold easing of monetary policy. By adopting a new (higher) inflation goal of 2%, Abe is getting what he wants. And the market loves it.

The main catalyst for the recent rally in the Japanese market has been the weakening yen, which makes Japanese exports more competitive and boosts earnings from overseas for Japanese corporate giants. That's why car maker Toyota Motor (TM) is up 35% in the past three months, and Sony (SNE) has soared over 50%.

I believe that although the Japanese market has already rallied by a third in yen terms, the Japanese market could rally another 40% this year.

Here's why. In terms of stock ownership, Japan is all about foreign investors, who make up about 70% of the trade volume. At the same time, most investors are underweight Japan. So as more and more investors increase their allocation to Japan, I believe you will see the market continue to rally.

Comparing the performance of the hedged WisdomTree Japan Hedged Equity Fund versus the unhedged iShares MSCI Japan Index (EWJ) over the past three months, it’s clear that a good chunk of the Japanese market's gains in yen disappear when converted into US dollars.

The yen's recent decline has given a real boost to the Japanese stock market. But investors in unhedged Japanese equity funds saw much smaller gains. And with the government (and now the BoJ) committed to devaluing the yen, you need a way to hedge against the declining yen so those gains can translate directly into US dollar terms.

Your solution? The WisdomTree Japan Hedged Equity Fund. This ETF hedges its exposure to the yen, while investing in some of Japan's largest exporters. DXJ has reeled in $1.4 billion so far this year, including an inflow of $335.6 million in a single recent week.